The London Stock Exchange (LSE)’s decision in April to abandon plans to start trading contracts for difference (CFDs) on its order book highlights the difficulties investors face in converting an over-the-counter (OTC) product into an exchange-traded instrument, according to a new report from research and consulting firm TABB Group.
The exchange had planned to offer a combined CFD and equity order book, where exchange-traded CFDs based on FTSE 100 equities would trade with and alongside their underlying cash equities, allowing firms to hedge their equity positions. The contracts would have been centrally cleared by the LSE’s main clearing house, LCH.Clearnet Ltd.
However, in part thanks to the global financial crisis, the service failed to attract the support of prime financing partners, dealers and high-frequency traders, which led to its indefinite postponement.
The TABB report, ‘Contracts for Differences: An OTC-to-Exchange Fable’, described the failure as a missed opportunity for regulators and dealers to unite and demonstrate to the financial markets industry that an OTC derivative can be moved to an exchange.
The report’s co-authors, TABB’s director of research Adam Sussman and financial journalist Will Rhode, said that certain components of an OTC derivative do not translate into a transparent, real-time, time-stamped execution environment.
One of these components is the way in which high-frequency traders employ the give-up process. The give-up process ensures trades executed by hedge funds are in the name of their broker. High-frequency demand for CFDs depends on the give-up process and stamp duty exemption, and while the LSE secured the stamp-duty exemption for its initial offering, it couldn’t promise the give-up process, said Rhode.
On the prime financing side, TABB said that although prime brokerage IT spend is expected to decline by as much as 40% through 2010, the outlay required for CFD expenditures of between £150,000 and £2 million proved too much for banks.
“The biggest losers from the listing failure must be the investment banks themselves,” said Sussman in the report. “Some of them could be accused of short-sightedness for their role in not bringing the product into fruition. Although the prime broker divisions will preserve their hefty margins in the OTC market, they will fail to see an expansion in the product’s appeal, as well as the attendant increase in volumes and liquidity.”
The failure could bode ill for other efforts to transfer OTC contracts on-exchange. “The devil is in the detail. Just as there are nuances of the OTC CFD market that seem unable to be ported over to the exchange model, regulators and exchanges worldwide may learn the same is true for many of the OTC derivatives now under discussion,” said Sussman in the report. “Although part of the appeal of an exchange-traded listing, including centralised clearing, is to enhance transparency, increase the number of participants and thus generate additional liquidity, there is no guarantee the listing will succeed.”